The tax treatment of unpaid present entitlements (UPEs) has long been a subject of scrutiny and debate in the tax world. This article considers the recent key decision in Bendel and Commissioner of Taxation (Taxation) [2023] AATA 3074 (Bendel’s case). The decision challenges established practice of the Australian Taxation Office (ATO) to deem UPEs to corporate beneficiaries as Division 7A loans.

BACK TO BASICS – THE LAW

Division 7A of Part III (Division 7A) of the Income Tax Assessment Act 1936 (ITAA 1936) operates to ensure private companies do not make tax-free distributions of profits to shareholders or their associates. The distributions may be via payments, non-arm’s length loans or loans generally more favourable to the borrower than those complying with section 109N of Division 7A (Soft Loans), or the forgiveness of debts.

Division 7A outlines circumstances where loans will be treated as unfranked dividends. In summary, a private company will be taken to pay a dividend if:

1. A private company advances a Soft Loan in a financial year;
2. The Soft Loan is not fully repaid by the company tax return due date or earlier if lodged prior to lodgement date (lodgement date),to the extent of the shortfall;
3. The private company is not exempt from being deemed to have made a dividend payment (for example where the loan is on commercial terms, which requires it to be on terms no more favourable to the borrower than those prescribed by Division 7A); and
4. The borrower is a shareholder or an associate of a shareholder of the private company.

The definition of a “loan” under Division 7A is broader than a simple loan comprising a payment of money and an obligation to repay. It can also include:

• advance of money;
• financial accommodation;
• any payment by direction to a third party where there is an express or implied obligation on the shareholder or associate to repay the amount; or
• any transaction in whatever form which in substance effects a loan of money.

Where a “loan” is deemed to have been made and not repaid or placed on complying Division 7A terms by the lodgement date, the private company will be deemed to have paid an unfranked dividend to the recipient in that subsequent financial year.

WHAT HAPPENED IN 2009?

On 16 December 2009, the ATO issued draft ruling TR 2009/D8, which later became TR 2010/3 (Ruling). The Ruling provided the ATO’s position on when a private company with a UPE from an associate trust is considered to have made a “loan” to the trust for Division 7A purposes.

The ATO also issued PSLA 2010/4 (PSLA) which provided options for holding an amount representing a UPE on ‘sub-trust’ in a manner that would not trigger Division 7A despite the UPE having not been discharged or placed on Division 7A complying terms. Specifically:

• Option 1: invest the funds representing the UPE on an interest only 7-year loan with annual interest payments at the benchmark rate. The ‘benchmark interest rate’ is the ‘Housing loans; Banks; Variable; Standard; Owner-occupier’ rate last published by the Reserve Bank of Australia before the start of the income year. The principal of these loans is required to be repaid at the end of the 7-year loan.
• Option 2: invest the funds representing the UPE on an interest only 10-year loan with annual interest payments. The principal of these loans is required to be repaid at the end of the 10-year loan.
• Option 3: invest the funds representing the UPE in a specific income producing asset or investment with annual income or returns dependant on the economic performance of the specific asset or investment and the principal/capital committed and any capital growth being required to be paid to the private company by the lodgement day of the tax return of the private company beneficiary for the year in which the investment ends.

Loans under these arrangements (especially Options 1 & 2) have previously allowed for better cash flow for the borrower than the principal and interest payments normally required to satisfy the terms of a complying written loan agreement. However, groups utilising these options are now facing significant challenges due to rising interest rates. The benchmark interest rate for the 2022-23 year was set at 4.77% pa in May 2022, but for 2023-24 the rate increased to 8.27% pa. Consequently, borrowing costs may now far exceed interest income leading to several tax and commercial issues, for example:

• Entity no longer carrying on a business: it may be argued that where there is little, or no, prospect of an entity making a profit that that key indicia of ‘carrying on a business’ may fail. This may affect several tax rules including section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) about income according to ordinary concepts, the second limb of section 8-1 (the general deduction provision) and Division 152 which outlines the small business tax concessions.
• Borrowing and bank loans: with increased interest expense in your profit and loss statement bank covenants (especially interest coverage ratios) may be impacted triggering a default event under group finance facilities. Additionally, if losses increase because of the borrowing expenses, then borrowing capacities of entities may be further affected.

Now is the time to start considering different funding alternatives for these loans/UPEs. Taxpayers should explore alternatives including early repayments or reducing reliance on these loans through restructuring, as discussed below.

WHAT CHANGED IN 2022?

Fast forward to 2022, and the ATO withdrew the Ruling and PSLA and replaced them with Taxation Determination TD 2022/11 (Determination). The Ruling and PSLA continue to apply to UPEs before 1 July 2022.

The Determination applies to a wider range of circumstances than the Ruling and PSLA. Under the Determination the ATO considers:

• where a corporate beneficiary is made presently entitled to trust income, which is not paid on or before 30 June, a UPE arises; and
• where that corporate beneficiary has knowledge of the UPE, evidenced when accounts are drawn up, but does not demand payment within a reasonable period after finalisation of the accounts (generally by 30 June the following year); and
• as a result, the private company beneficiary makes a loan to the trustee under the extended definition of a “loan” for Division 7A purposes in that following year.

The ATO now considers that Division 7A applies unless the unpaid distribution is (placed on complying Division 7A loan terms or) placed in a sub-trust where the funds are not mixed with the main trust funds and are invested solely for the benefit of the company. This position is similar to Option 3 under PSLA which was not often used due to its burdensome and impractical nature. Arrangements outlined as Options 1 and 2 in the PSLA can no longer be entered into for UPE’s created on or after 1 July 2022.

THE BENDEL CASE – A GAME CHANGER?

On 28 September 2023, Deputy President Frank O’Loughlin KC of the Administrative Appeals Tribunal handed down his decision in the Bendel case. The case involved several trust entities which conducted an accounting and registered tax agent practice, controlled by Mr Bendel and/or participated in property syndicates operated by Mr Bendel and his brother.

Whilst addressing several legal questions, the key question was:

Did a corporate beneficiary make a “loan” within the extended meaning of s109D(3) of ITAA 1936 in Division 7A, to the trustee of a trust?

The Tribunal determined the answer to be no.

The Tribunal noted:

[101]….the necessary conclusion is that a loan within the meaning of s 109D(3) does not reach so far as to embrace the rights in equity created when entitlements to trust income (or capital) are created but not satisfied and remain unpaid. The balance of an outstanding or unpaid entitlement of a corporate beneficiary of a trust, whether held on a separate trust or otherwise, is not a loan to the trustee of that trust.

The Tribunal further observed that UPEs are more specifically dealt with by Sudivision EA of Division 7A, not Subdivision B (s.109D is part of that Subdivision).

Therefore, UPEs owing by a trust to a corporate beneficiary are not Division 7A loans but instead place the private company with the UPE in the shoes of the trustee in the limited circumstances where Subdivision EA would apply. Subdivision EA applies to circumstances where a trustee creates an UPE in a private company and transfers the underlying cash (or property) to a shareholder or an associate of a shareholder by way of certain payments or any Soft Loans, or by the forgiveness of such loans. However, in the absence of those circumstances (eg when the trustee retains the cash for use in the trust) Subdivision EA will have no application.

WHAT NOW? 

Our key takeaways for advisors and clients:

1. The Bendel case clearly challenges the ATO’s view in the Determination as well as its now withdrawn predecessor and has injected fresh uncertainty into the tax landscape. At this stage, with the case just published, the Determination remains in place and has not been withdrawn.
2. We would expect that the decision will be appealed by the ATO. However, this is not a given. Tribunal decisions are not precedential and therefore the ATO is not forced to act in accordance with the Bendel The Determination may remain as an alternative view of the ATO going forward. Nevertheless, this does not mean that it would not be open to challenge by another taxpayer. Even if successful, the Taxpayer may still have to contend with a s.100 A ITAA 36 assessment if for instance the balance due under UPE was static for an extended period and the other requirements of that section were satisfied.
3. It is important to remember that all ATO guidance is not law, but rather how the ATO interprets, applies and/or administers the law. There are many contentious views held by the ATO on various areas and it is for the judiciary to provide a legal explanation. Ongoing matters with the ATO or new audits that arise post Bendel’s case must be approached with significant caution whilst the appeals process is ongoing (if it is).
4. For some time, Subdivision EA has been carved out from consideration in this space. However, it will likely come into greater focus (subject to appeals) and therefore a careful review or discussion with your advisor should be had on this topic.
5. A group may simply not be able to afford the higher benchmark interest rate (8.27% pa for the 23/24 FY), the related increase in company tax on the additional interest under complying loans and/or the extra “top up” tax for recipients of franked dividends. Group members need to directly or indirectly, through a set off or allied arrangement, meet their financial commitments to the private company to ensure no unfranked deemed dividends arise under Division 7A. With the benchmark interest rates rising, now is the time for groups with the above issues to carefully consider what can be done to ease the burden of existing Division 7A loans prepared in accordance with the withdrawn PSLA. With the careful and proper restructuring of the composition of intra group loans, assets and affected entities, the same may reduce various tax exposures.